Tuesday, July 31, 2007

If you are Elizabeth Cabrera-Rivera, you steal Jose Lara's identity to commit loan fraud by getting a no-documentation mortgage ("no-doc mortgage") for a $419,000 townhouse in his name. Mr. Lara only discovered the plot when he received a $2,800 refund for closing costs and the jig was up for Cabrera-Rivera.

It gets even stranger.

Elizabeth Cabrera-Rivera committed the crime because she could not get a mortgage in her own name. However, she did not abscond with the cash. Nor did she try to get free housing by defaulting on the mortgage and stretching out the eviction. No, our heroine dutifully paid the monthly mortgage payments on time.

Yes, she was buying a townhouse for Jose Lara. Sadly, it sounds like she could have been very successful building equity/savings in her own name while renting. Instead, decades of her toil gets her to that magic moment when the mortgage is paid off . . . for someone else.*

How is that better than renting?

How brainwashed must you be that you "have to" have a mortgage, even if it is to build someone else's home equity?*

* Update 11/12/07: Cabrera-Rivera later transferred the deed to her name (see comments).

The previous leverage article covered how the common method for measuring leveraged Return on Investment (ROI) can mislead you by underestimating the work and risk. Add overly-optimistic “magic” numbers to inflate ROI and this article shows how the combination of rosy estimates and ignored risk can trick you into a bad investment.

We will start with the same example as last time:$250k: invest 100% cash (unleveraged) or 10% cash with 90% loan (leveraged)?

“As you can see, even though your risk increases with leverage, it might be a wise choice when you can increase your ROI by as much as 80% (16.9% is 84% increase over 9.2%) over the full cash in front option.”

The promised 7.7% spread (16.9 over 9.2) was not impressive enough so the author used a percentage of a percentage to make the pro-leverage number 10-times bigger (80%--Who doesn't want to earn 80%?). Almost doubling your ROI would be a good thing but let’s not get carried away too soon.

The pro-leverage conclusion depends on magic numbers.

How many rental markets have perfect 100% occupancy rates, i.e. no vacancies at all between tenants, and no missed payments? Here are some real-world rental occupancy rates/vacancy rates that I quickly found to see how the examples perform with real-life inefficiencies:

Tuesday, July 24, 2007

A recent leveraged-investment discussion revealed that people can calculate a high Return on Investment (ROI) from borrowing by not counting the debt principal as a cost and (in one case) not counting the debt interest as a cost.

Financial analysts can claim that debt gives the higher ROI by not counting the debt principal as part of the investment, yet counting the net returns from debt (your ROI sprouts from "nothing"). The argument is that the debt is "not your money," although a credit check of your name would not agree completely and at the very least the argument ignores the legal liability, risk, insurance requirements, effect on credit score, credit score's effect on other loan rates, etc.

Infinite ROI, infinite profits

Excluding the debt principal from the initial value of an investment certainly can raise the apparent ROI. However, that argument suggests that 0% downpayment gives you infinite ROI when we all know that, for any given dollar amount of investment, you would be poorer by borrowing more of it and richer by borrowing less of it (as in the "Consider a choice" above, and the example below).

Wait, there is no such thing as a free lunch after all

While a high ROI seems efficient, at some point you want to maximize your profits in dollars rather than percentage points. You cannot buy lunch with percentage points. You need dollars.

The NOI trend gives you an idea of your hard-earned money that you keep by putting a larger downpayment on your mortgage (although this is a rental example).

These types of examples are very common to extol leveraging but you can see the trend that the more you pump up the ROI, the less money you make.

Cocktail-party bragging rights to the higher but leveraged ROI will cost you $18,879.

How high an ROI do you want?

(PS: The NOI informs you that the leveraged ROI is inflated because it ignores that you left $225k cash idle and (apples to apples) the actual leveraged ROI here is only 1.7% ($4221/$250k), or 0.9% ($4221/$475k) if you include the $225k mortgage to discount for debt risk.--Note added 7/25/07, last updated 7/30/07)

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Leveraging multiplies scale, volume, and risk but I will leave that for a future article. Alternate uses for the same money (opportunity costs) such as stocks or arbitrage are separate choices and each can be leveraged or not leveraged.

Some people make the “you have to live somewhere” argument to ignore most mortgage costs and make the home-as-investment accounting look better (hiding liabilities "off-book" a la Social Security). However, that argument backfires and incurs additional costs that still invalidate the arbitrage game of borrowing to invest in a home as an investment.

"You have to live somewhere" cuts both ways.

The Replacement House Cost: “You have to live somewhere” means that you cannot sell your house without buying a replacement house--or other accomodation, but the "housing ladder" ideal is to "trade-up" and most people do not transfer to a lesser market, smaller house, or rental (although if you had tried to rationalize by subtracting rent value from your house purchase, be consistent and add rent cost to your home-sale costs if you do not buy a replacement house). Therefore, the cost of your replacement house is part of your transaction costs to realize your gain on your first house—and many people would find the result to be a net loss if they accounted correctly.

The Deflator Negates the Appreciation: “You have to live somewhere” negates most or all house appreciation because most people will replace a house with another house that appreciated by a similar amount. The key to “real” appreciation or “beating inflation” is a differential price rate between 2 different classes of commodities (say, real estate v. the CPI’s non-house basket of general goods) or 2 different markets. i.e. when your item increased more than the item that you want to buy, you can trade at a favorable exchange rate (a basic idea most associated with, but not limited to, currency trades). By re-investing in the same asset class and market, you eliminate the arbitrage possibility; you eliminate the possibility of beating inflation. In other words, when you calculate your real appreciation from your house-sale as investment, the proper deflator for the first house is the replacement house’s appreciation over the time period that you lived in the first house (do not use a CPI deflator). Many people will learn that trading keys is like getting a 10% raise to buy items which cost 10% more--they realize no real net gain from appreciation. The profit truism is “Buy low. Sell high” but sell-high-then-buy-high makes no money. You are running yourself ragged on your hamster wheel.

$XX,XXX Transaction Costs to Middlemen: “You have to live somewhere” requires the transaction cost of buying replacement housing and can lower your house-sale net gains by tens of thousands of dollars (compared to the $10 transaction fee that you pay to Ameritrade to realize your stock gains). You (the re-buyer) pay the realtor costs, new loan origination costs (points), closing costs, moving costs, and any other costs plus the value of time and inconvenience to move. The seller pays the realtor with the buyer’s (your) money. The old joke is that the buyer is the only one bringing money to the table and everyone else is a taker. Various “cash-back” games or other incentives usually amount to additional debt heaped onto the buyer (such as your “free” granite countertops at $10,000 plus 6% interest).

No net appreciation + high transaction costs = real net loss

Certainly some people make money and you could avoid a replacement-house purchase by moving back in with your parents--but then you could have lived with parents all along and worked as landlord to your mortgaged property--but then you did not need a mortgaged property at all and your money could have earned more elsewhere debt-free.

The greatest financial scandals of the past century were caused not by the specific financial product purchased but by the method of purchase—leveraging, i.e. borrowing to invest on a gamble that the investment would win the race against the loan interest (1920s stock market, 1980s junk bonds, 1990s derivatives, 2000s day-trading). People borrow because they see a high-margin arbitrage opportunity (an arbitrage opportunity is a disequilibrium in asset prices, a profit potential, which invites trading until supply and demand correct the gap). A low arbitrage margin that is below borrowing costs means that it only pays to invest cash and therefore your total profits (or losses) are limited by your amount of cash. For a house investment, you would choose a house price that did not exceed your cash, or you would find co-investors to pool cash to meet the house price.

If, however, expected profit exceeds the cost of borrowing, it seems as if you can make money far beyond your ordinary means by borrowing as much as possible--but this belief has ruined many people. It is one thing to take $100 from your wallet and lose it in the casino. It is quite another to borrow $10,000 and lose someone else’s money in the casino—and then have to pay back $30,000 after interest. Derivatives are not “bad” (they are a useful tool) but they got a bad name when the real culprit was foolish leveraging. Home mortgages are leveraging.

A Home Is an Especially Poor Choice for a Leveraged Investment

Leveraging to invest is risky but at least makes some sense when the investment appreciates faster than the debt (borrow at 5% if the asset grows at 10%)--and there is no guarantee on that. Moreover, owner-occupied, non-rented, residential real estate is one of the worst candidates for leveraging because the odds of such real estate netting more than the real borrowing costs is very low. In fact, you are almost certain to lose money.

Price Volatility with Sticky Ownership Is a Bad Combination The Risk of Short-Term Market Timing

Volatile prices require proper timing of the market, which requires agility to buy and sell at the proper time. A home (primary residence) has volatile pricing but is very illiquid and fails miserably at these investment requirements. Some experts such as Ben Stein actually tell people not to bother timing and instead to buy what you want when you want it--and many do just that. You will hear examples of some people who, often by accident rather than plan, bought and sold at the optimum times and made a killing on price fluctuations but you also can find people who won the lottery yet that does not mean that buying lottery tickets is a good financial plan. Houses can take months to sell and most people sell for non-investment reasons (change jobs, divorce, etc.), so sales are rarely timed to maximize investment profit and might even result in the dreaded buy-high-sell-low.

Arbitrage Doesn't Live Here Anymore:The Long-Term Investment Return Is Too Low To Pay for a Loan

The real (inflation adjusted) long-term appreciation of US residential real estate has averaged about 1% annually (or less) since 1890 while the real, after-tax, net mortgage cost can be 2-4 times the home appreciation rate. Borrowing at 3% to earn 1% is a loss. Borrowing at 2% to earn 1% is a loss. Nominal-dollar borrowing at 5% to earn 4% is a loss. There is no leveraged arbitrage profit possible in the long term, absent a quirk of timing. Saying that the debt is for a home does not change the laws of mathematics. In other words, a house bought with cash might tread water and barely hold its value over the long haul but a loan cost easily can put a house investment in the red. Even if you live in the house for 60 years (twice the common mortgage term), when all the carrying costs are factored, you probably are losing money by borrowing to invest in a home.

Pay interest if you must but do not deceive yourself that spending more than you are earning is a road to fabulous riches.

A basic investing rule is not to risk more than you can afford to lose. An easy way to follow this rule is to risk savings and not borrowings, i.e. do not leverage investments.

Avoiding “rent” does not save the investment model, as I will cover in 1 or 2 coming articles.

The Vanguard 500 S&P500 index fund is popular in the buck-o-sphere (PF blogosphere) and bloggers often cite its historical annual rate of return of 12% since inception in 1976. However, besides the usual caveat that past performance is no guarantee of future performance, too many people ignore another vital factor. The Vanguard 500's real performance is not nearly as stellar as many believe.

Dough Roller recently remembered earning more than 10% on Certificate of Deposit (CD) during the high inflation of the 1970s/early-1980s. Indeed, consumer prices rose 13.3% in 1979.

Forgetting to count inflation--and forgetting that past inflation was quadruple current official rates--will cause you to overestimate historical investment performance. The Vanguard 500 averaged 12% annually since mid-1976 but double-digit inflation makes a 12% return pitiful. A fund with 12% growth during 12% inflation is no better than a fund with 3% growth during 3% inflation.

Before you "beat the market," at least beat inflation.

"Beating the market" compares your fund relative to other funds, which could mean that your fund lost a lot while other funds lost even more. This is small consolation, since schadenfreude will not pay your bills.

You need real, after-tax gains to buy food in retirement.

Use real rates of return (not nominal rates of return) to get a more accurate measure of historical performance. This lesson applies to any investment.

My article noted how a 2001 Fool.com article predicted a 12% annual return on investment (ROI) for an S&P500 fund but in early 2007 the 10-year average was only 7.7% (even using "Bull's Math" (optimistic Wall Street math)).

The second mistake is forgetting what an average is.

The problem for your retirement nest-egg is that a return to 12% annually does not fix the predicament. To average 12% after a decade of 8%, you need the next decade to provide over 16%. However, we are coming due for a recession (cycles are inevitable) and a steady 16% for a decade seems unlikely. Moreover, if a coming particular year does “only” 12%, you need another year at 20% to average a 16% decade to make up for the first decade’s 8%. If the S&P500 returns a modest 8% in a future recession, we might need the S&P500 later to return 25% simply to average 12% in the 21st Century.

“Experts” apparently made this mistake in financing the housing bubble.

Experts at an early-2006 conference on home-equity-loan securitization assumed a worst-case scenario of +3% asset (home) appreciation per year. It seems as if they assumed the worst stress-test condition to be the long-term trend rate of residential real estate appreciation, barely treading water with inflation (if we continue 2-3% core inflation).

The bigger they are, the harder they fall.

The glaring error is assuming that the price basement will be the historic average, rather than the lower numbers that created the average. +1 and -1 average to 0. It is mathematically impossible for every year to be either average (0) or above average (+1). Some years must be below average (-1) to make the average. If you then had a few years at +10 (far above average), you cannot assume that your future floor will be 0 (the average) because now you need a few years at -10 (far below average) to return the average to 0.

The big problem ahead

Standard & Poor's (S&P) and Moody's are reducing the ratings of mortgage securities, which is like telling a new owner, after the purchase, that his/her "6-pack" of soda only has 5 cans, his/her "30mpg" car only gets 20mpg, or his/her "3-bedroom" house only has 2 bedrooms.

The valuation errors contributed to the housing bubble by (1) overestimating the profit in home-mortgage sales, (2) thus overselling the financing product, (3) thus causing the inflation of too many dollars chasing too few assets (the home, necessary to cash the profit on the home-mortgage product), (4) thus contributing to the asset bubble, (5) but also underestimating the risk, (6) thus underdiscounting/overpricing securitized debt/CDOs, (7) thus sticking buyers/investors with insolvent lemons, (8) and the double whammy of evaporating home equity and evaporating securities equity creates yet to be seen ripples in pension/retirements funds, consumer spending, employment, Federal Reserve monetary policy, stock market performance (+25% or -10% for the S&P500?), and the economy writ large.

Thursday, July 5, 2007

I have seen 3-hour delays and yesterday more than a day's delay between blog post and the post's appearance on PFblogs.org. In the recent case, it seemed that the post never appeared on PFblog.org's first page because it posted in an already-buried position.

What affects the delay and what delays do you encounter?

Update 7/6/07: This post did not appear on PFbolgs.org until about 6 hours later and was buried on page 3 (51-75) and apparently never saw the first page.

How can we fix this?

Update 7/6/07: PFblogs.org quickly replied (thank you) that Feedburner was slow to record my content so I sent an Atom URL to PFblogs.org and a subsequent post appeared on PFblogs.org's first page an hour later.

The post appeared at about 4th place on the first page, inserted below posts that had already been there, so somehow others are getting a quicker turn-around time.

You will have a US federal tax deduction of about $3k and a tax credit of $1k per child, which means that $1k-$2k of child costs will not lower your previous discretionary income at all. Even with a few pediatrician check-ups, depending upon your health insurance and tax brackets, you might make a profit off your baby.

Play time

Patty Cakes and mud pies are free.

Durable goods

Freecycle.org seems novel only if you are unaware that shared hand-me-downs are the normal way that an entire extended family would outfit new parents for generations.

Furniture: It used to be normal to use “grandma’s crib,” the one possibly hand-built by your great-grandfather in 1900, the one in which your mother slept and you slept. In between, your aunts and cousins slept there. “A diaper-changing table” was known as “a table” or “a blanket on the floor.”

Clothing: It used to be normal for children to wear their older cousins' outgrown clothes, and for a younger brother to inherit his older brother’s winter coat (that is 1 coat for 2 children, not 5 coats for each child). Your 2-year-old niece has absolutely no use for her 6-month-old-sized sneakers.

Toys/books (including educational): It used to be normal to recycle toys, especially the very early baby ones that a more possessive toddler scarcely remembers as “mine.” Unless your family changed language, items such as an older, in-the-extended-family “Jack and Jill” book should be fine.

You might have some cost for new and replacement durable goods but spending a fortune is very often voluntary rather than necessary.

How to turn free or almost free into a $14k/yr loss

Musings on Personal Finance mentions that the average middle-class family spends $4-5k/yr on a baby's first 2 years but remember that is what is spent, not what is necessary. SureBaby.com claims $9-11k for the first year but that includes “baby furniture” and “baby gear.” MSN/Money claims $14k/yr (a quarter-million dollars to age 18) but that is for your “basic upscale baby.”

If you are determined to commercialize your child, you certainly can find ways to part with your money for all these services that the new Mom’s Mom and Grandma used to provide for free:

$400 to learn how to give birth (Lamaze class).

$80/hr to learn how to give milk (“lactation consultant”).

$200-$400 to learn how to play/bond with your baby (“mommy and me yoga” class).

$300 birth announcements.

$60 Teletubbies cake.

Voluntary big-ticket items

Daycare: One reason that the “traditional family” has been traditionally common is because it (including Mom, Dad, Auntie, Grandpa, cousin babysitter) does not need commercial daycare cost. However, people are free to choose non-traditional families and commercial daycare. Look at these 3 real families; one couple chose the stay-home-spouse method to avoid commercial daycare, another couple chose to stagger their 2-job work schedule to avoid commercial daycare (even 2 single parents could make a similar arrangement), and another couple decided that they both wanted to work “9-5” so they chose commercial daycare as a lifestyle choice.

Education: You can do homeschooling relatively inexpensively (a good encyclopedia CD-ROM provides impressive bang-for-your-buck since even most parents know only a tiny fraction of its knowledge). Public education is expensive but you pay for it through taxes whether you have children or not so having a child does not change your cost much. You can choose to pay for private school in addition to public school. You can choose to pay for college, or not pay and let your new adult son or daughter decide how to spend his/her own money.

Housing: It used to be normal for young children to share a room or to have a "girls' room" and a "boys' room." Even the affluent Brady Bunch had only 2 rooms and 1 bathroom for 6 children. You also can split a room into 2 rooms with affordable interior walls.

Vehicles: It used to be normal for 2 families to fit inside a single mid-sized sedan for family outings. Even the extra space for baby-seat regulations does not require today’s smaller families to buy a $30k minivan or SUV—unless it is to fit the $10k of ski equipment and Gameboys.

The "Dog Food Effect": Who is the spending really for?

Spending to provide a healthy, happy child is different from spending to use a child as a billboard for the parents’ ostentation. Babies know when they are warm but not when they are fashionable. Many of us have seen the child who unwraps a present and throws the toy aside to play with the packaging. “Dollar store” toys can be just as astoundingly educational and fun as boutique toys when you are fresh out of the womb—it is all new to you.

Many baby products are examples of the "dog food effect," marketing slang for when a product must appeal to the buyer rather than to the actual user of the product. Choose safety and fun for the child over prestige for the adult.

By the time the child has been socialized to fashions and brands, the child can start thinking about getting a “job” to pay for wants: The “lemonade stand” stage is an important part of education and socialization.